November High Yield Credit Update

Monthly Commentary

Volatility was re-introduced to the high yield marketplace in November, marking the
third (and seemingly final) dip of an otherwise positively inclined calendar year.

2017 Year-to-Date High Yield OAS
Three Shocks to an Otherwise Linear Path Tighter

Source: Bloomberg

While the dislocations in March and August were triggered by factors more macro
in nature (recall, the adverse feedback loop created by a glut of new supply in March
and the North Korea driven risk-off in August), the sharp ~50bps correction in the
first half of November was certainly led by the micro. Let me elaborate. In recent
months, we have highlighted the fundamental stresses facing credits in a growing
number of discrete sectors, such as retail, supermarkets and wirelines (and the
resulting dispersion in bond level risk premiums within the high yield market).
As we moved through the heart of third quarter earnings for high yield issuers in
October and November, underwhelming results both accelerated and broadened the dislocation, most notably to large capital structures in the healthcare, cable/satellite sectors. This, coupled with the sell-off
in the unsecured debt of market bellwether Sprint following the unexpected termination of merger talks with T-Mobile, ultimately
provoked a broader risk aversion that transmitted throughout the marketplace via indiscriminate outflow-driven selling. This
represented an interesting microcosm (and sobering reminder) of one of the mechanisms through which stress in seemingly
isolated credits can permeate the rest of the market.

Market Performance

Returns for the high yield asset class were negative for just the third month this year as the underperformance in the first 15 days of
the month (-1.3%) was only partially retraced by the recovery in the second half (+1.1%). Cumulatively, high yield bonds returned
-0.25% in November.

Source: Barclays

With the epicenter of the sell-off this month being very idiosyncratic in nature, there wasn’t a consistent theme when comparing
performance across ratings buckets (e.g. risk-on vs. risk-off). Indeed, Single-Bs underperformed both BBs and CCCs as many of
the discrete laggards, particularly in the cable and telecom sectors (i.e. Altice, CenturyLink, Frontier, Sprint), are rated Single-B by
the agencies. Generally speaking, however, higher quality credits found greater support once the volatility broadened as investors
sought relative safety.

Source: Barclays

At the sector and security level, several notable catalysts created rather large cracks in some substantial capital structures. Beginning with wirelines, while prices of Frontier and Windstream unsecured bonds continued to trend lower (both the result of declining operating performance, though specific to Windstream is its ongoing battle with litigious hedge fund Aurelius), it was CenturyLink that caused the sector to underperform meaningfully this month. The company reported third quarter earnings that underwhelmed investor expectations and bonds (and the stock) sold-off as a result (CTL unsecured bonds were down ~10-12pts in little over a week). Turning to wireless, the surprise dissolution of merger talks between Deutsche Telekom (T-Mobile) and Softbank (Sprint) caused the Sprint capital structure to re-price lower as investors discounted the large M&A premium then embedded in bond prices. Cable/satellite credits also experienced broad weakness in November, both a result of idiosyncratic factors as well as technical pressures (during periods of elevated cash needs, either to fund outflows or invest in new issues, this sector is typically targeted by investors as a source of funds). Altice bonds traded down across its massive and complex debt structure, though most acutely in its international credit boxes, as investor confidence in the stability of the levered conglomerate began to wane. Finally, healthcare didn’t disappoint in disappointing as issuer after issuer (notably Community Health and Envision Healthcare) released third quarter results that confirmed a similar pattern of lower admissions and declining profitability that appears to be impacting the healthcare space.

Source: Barclays

Market Technicals

Following two months of steady net inflows into the high yield marketplace (+$1.9bn in September and +$1.0bn in October), a brief, though systemic risk aversion emanated from a growing list of idiosyncratic catalysts, resulting in a large exodus of retail money from high yield funds during the first two weeks of November. High yield funds reported -$5.4bn in net outflows, anchored by a -$4.4bn net outflow during the second week of the month alone (the fourth largest weekly outflow in reported history). Investor nerves steadied in the second half of the month, however, stabilizing capital flows and market prices.

Large Capital Outflows Helped Transmit Idiosyncratic Tremors Throughout the Marketplace

Source: Lipper, JPMorgan

After observing two months of issuer friendly conditions in September and October, and staring down only a handful of weeks left in
the year before the primary market shuts down, issuers and banks were keen on bringing deals in November. Approximately, $26bn
in USD-denominated high yield bonds cleared the primary market during the month, which, coupled with the spike in retail outflows,
created adverse technical conditions which amplified the sell-off mid-month (a la March).

High Yield Net Supply ($MM)

Source: Barclays

Fundamental Trends

Following a several-month lull in the number of corporate defaults (one in September and two in October), November saw a slight
uptick in default activity with six companies defaulting on their obligations (loan and/or bond) during the month. The $7.4bn in
notional defaulted debt ($2.6bn bonds and $4.7bn loans) represented the highest monthly volume of 2017, indicative of the very
benign default environment this year. Cumulus Media, a highly indebted national radio broadcaster that filed for bankruptcy in
order to restructure its balance sheet, was the largest default in November. With 2018 forecasts having been recently published
by the strategist teams at the various investment banks, it would appear consensus calls for an extrapolation of the recent default
activity over the next 12 months, specifically +/-2%. While this may prove correct, we note the growing level of stress across several
core sectors, increasing dispersion in credit risk premiums and the maturity of the credit cycle all leave us skeptical.

Bond Level Dispersion has Historically Been a Good Leading Indicator of Market Stress/Rising Default Activity

Bond level dispersion: differential between 90th and 10th percentiles to the median spread across IBoxx IG and HY indices